On 30 July 1998, Alan Greenspan, then Chairman of the Federal Reserve argued that: “Regulation of derivatives transactions that are privately negotiated by professionals is unnecessary.” In October 2008, the now former Chairman grudgingly acknowledged that he was “partially” wrong to oppose regulation of credit default swaps (“CDS”). “Credit default swaps, I think, have serious problems associated with them,” he admitted to a Congressional hearing. His current views on wider derivative regulation remain unknown.

Politicians and regulators globally are currently busy drafting laws to regulate derivatives. A common theme underlying the activity is an absence of knowledge of the true operation of the industry and the matters that need to be addressed. As Goethe observed: “There is nothing more frightening than ignorance in action.”

The author Thomas Pynchon warned: “If they can get you to ask the wrong questions then the answers don’t matter.” Simplistic causes and solutions may prevent real issues in relation to derivatives from being debated and dealt with.

Size Matters …

Based on surveys conducted by the Bank of International Settlements (“BIS”), the global derivative market as at June 2009 totalled US$605 trillion in notional amount. This is a large increase in size from less than US$10 trillion 20 years ago. The bulk of the activity takes place in the Over-the-Counter (“OTC”) market where derivatives are traded privately and on a bilateral basis between banks and clients. The OTC market should be contrasted with the exchange traded market where relatively standardised products are traded on formalised, regulated exchanges.

The outstanding amount compares to global Gross Domestic Product (“GDP”) of around US$ 60 billion. As author Richard Duncan points out in his 2009 book The Corruption of Capitalism, the outstandings in the global derivatives market at its peak in June 2008 (US$760 trillion) was equal to “everything produced on earth during the previous 20 years.”

Volume estimates are affected by double and triple counting and other statistical problems. There are also significant disagreements about the significance of the size numbers.

Derivative professionals argue that derivative notional amounts (the face value of the contract) are a stock measure (like assets and liabilities). GDP is a flow measure (i.e. income). So strictly speaking they are not directly comparable.

Derivative professionals also argue that the outstanding value is irrelevant as it is only the notional face value of contracts. They focus on the current value (around US$25 trillion) that can be further reduced after netting between dealers to around US$4-5 trillion. If the US$4 trillion in collateral (cash and government securities) held to secure the current value is considered, then they argue that the exposure is a negligible amount.

In effect, there is no risk. The size of the market doesn’t matter. As Laurence J. Peter author of the famous Peter Principal stated: “Facts are stubborn things, but statistics are more pliable.”

Current value is a calculation of the worth of the derivative contract if terminated today. It provides a useful measure of current price and risk.

The notional amount represents the actual amount of underlying assets that the trader is exposed to. The notional face value is the essential starting point of market size and any measure of leverage. The size of the market is inconsistent with the thesis that derivatives are merely a vehicle for hedging and risk management.

Current regulatory proposals do not attempt to deal with the size of the derivatives markets. The current debate about “too big to fail” banks may indirectly affect the size issue.

Approached to provide government aid to a company that claimed it was to big to fail, Richard Nixon advised: “get smaller!” Derivative regulators would do well to heed Nixon’s advice.

Grand Speculations…

Proponents argue that derivatives are used principally for hedging and arbitrage. In this way, they perform an economically useful function aiding capital formation and reallocating risk to those willing and better able to bear them. While they can be used for this purpose, derivatives are now used extensively for speculation, that is, manufacturing risk and creating leverage.

Stripped of quantitative hyperbole, derivatives enable traders to take the risk of the asset without the need to own and fund it. For example, the purchase of $10 million of shares requires commitment of cash. Instead, the trader can instead enter a total return swap (“TRS”) where he receives the return on the share (dividends and increases in price) in return for paying the cost of holding the shares (decreases in price and the funding cost of the dealer). The TRS requires no funding other than any collateral required by the dealer; this is substantially less than the $10 million required to buy the shares. The trader acquires the same exposure as buying the shares but increases its return and risk through leverage.

Derivative volumes are inconsistent with pure risk transfer. In the CDS market, volumes were in excess of four times outstanding underlying bonds and loans. In the currency and interest rates, the multiples are higher.

Investors searching for return drive speculation. Concerned about stagnant real incomes and inadequate retirement savings, individual investors seek out higher yielding investment structures, often based on derivatives. Pension funds and other institutional investors use derivatives to enhance returns to fully fund and meet their contracted liabilities. In an environment of diminishing returns and fierce competition for attractive investments, fund managers use derivative strategies to enhance returns through readily accessible leverage and capacity to create risk “cocktails”.

This pattern affects small companies as well as large companies. It is also evident in emerging as well as developed economies. In China, India and Korea, companies resorted to aggressive derivative strategies to augment earnings as profit margins on products were relentlessly forced down by competition and buyer pressure. Some strategies have led to significant losses.

The competitive advantage, if any, enjoyed by investors and corporations in speculative trading, especially in complex derivatives is unclear. Perhaps it is a lack of “horse sense” which as stated by Raymond Nash is “what keeps horses from betting on what people will do.”

Proponents argue that speculators facilitate markets and bring down trading costs, thereby helping capital formation and reducing cost of capital. There is little direct evidence in support of this proposition. Recent experience suggests that in stressful conditions speculators are users rather than providers of scarce liquidity.

Given derivatives are second order instruments deriving its value from underlying assets, the argument regarding liquidity is curious. In many cases, the derivative contract is far more liquid than the underlying debt, shares, currency or commodity. This is consistent with trading in derivatives having a significant non-hedging, speculative element.

Speculative activity amplifies rather than reduces volatility and systemic risks. Perversely, this may impede capital formation and also increase the cost of capital for companies.

A reduction in speculative activity would also arguable free up capital tied up in trading. This capital could be deployed more effectively within the economy.

Control of speculative activity in derivatives is feasible. This would require traders to show an underlying risk as a pre-condition to entering into a derivative contract. In the case of investors, it would also require the derivative contract being covered fully with available cash or other securities.

The concept is used extensively in the insurance markets. A similar concept is embedded in the hedge accounting standards currently in use.

Current regulatory proposals do not attempt to deal with speculative activity directly in the derivatives markets. Some U.S. insurance regulators have proposed controls on speculative activity in certain derivatives, such as CDS, by requiring an underlying position.

Amusingly, dealers now argue that the bulk of trading activity is actually for hedging purposes. It may have something to do with a more elastic definition of “hedging”. No evidence was offered. Dealers were probably following Mark Twain’s advice: “Get your facts first, and then distort them as much as you please.” In reality, probably no more than 10-20% of activity in the derivative markets is related to hedging.

The Obama Administration’s proposed “Volcker Rule” prohibiting major banks engaging in proprietary trading may, if implemented, affect speculative activity in derivatives. In the surreal theatre of U.S. regulation, the Senate Committee on Agriculture, Nutrition and Forestry, chaired by Blanche Lincoln, has introduced its own version of regulations. The controversial Section 106 prohibits banks using swaps from accessing the Fed’s discount window.

The proposal would prevent banks from hedging their own exposures using swaps as well as trading swaps. At a minimum, it would force banks to move their derivatives activities into non-bank entities. Transferring such activities would require additional capital (estimated at $20 billion or more) and also result in higher cost of funding for the derivatives activities. It is not clear how this proposal actually addresses any of the fundamental issues relating to derivative activities.

In the 1950s, two economists, Kenneth Arrow and Gerard Debreu, proposed a theoretically perfect world - known as the Arrow-Debreu theorem. To attain the nirvana of economic equilibrium, the theorem required there to be securities for sale for every possible state of the future – “state securities”. There should be contracts to buy or sell everything at any time period in every place until infinity or the end of the world, whichever was first. This utopian worldview provides the justification for allowing any and every type of derivative markets to be created.

Dealers argue that such structures are created in response to customer demand and to provide “financial solutions”. In my experience, clients rarely ask to be shown a US$/ Yen big figure stop with double-barrier conditional accumulator (with or without Elvis Presley pelvic thrusts). Complex structures are designed and sold (often aggressively) by dealers.

The major drivers for complex products are increased risk and leverage. Some structures are also designed to circumvent investment restrictions, bank capital rules, and securities and tax legislation.

A key issue is the use of “embedded” leverage. These arrangements are used to provide leverage to investors and corporations whose internal or statutory rules prevent borrowing to finance increased investments. Derivative technology is deployed to increase gains and losses for a particular event (such as a change in market prices of an asset) in accordance with customer requirements to provide the effects of leverage without transgressing their investment mandates.

Proposals to control bank leverage, in broad terms, lack understanding of the issues of embedded leverage and its use in financial markets.

Complexity is also related to profitability of derivative trading. On 19 March 1999, Alan Greenspan speaking at the Futures Industry Association Conference at Boca Raton, Florida remarked: “… the profitability of derivative products has been a major factor in the dramatic rise in large banks’ noninterest earning and … the significant gain in the overall finance industry’s share of American corporate output… the value added of derivatives themselves derives from their ability to enhance the process of wealth creation.”

The former Fed Chairman’s statement showed an alarming lack of understanding of the real sources of derivative trading profits. Many financial products are opaque and priced inefficiently to produce excessive profits – economic rents – for dealers. Efficiency and transparency is not consistent with high profit margins.

The majority of derivative transactions are standard and “plain vanilla” earning low margins with dealers relying on volume for profits. The bulk of dealer profitability comes from a few complex products. They also feed trading in standard products as dealers manage and re-allocate their risk from more structured transactions.

Complexity is also related to mis-selling of derivative products. Arcane structures create significant information asymmetry. Mis-selling of “unsuitable” derivative products to investors and corporations remains a problem. Expertise of purchasers is sometimes inversely related to the complexity of derivative products.

Currently, there are numerous disputes concerning derivative transactions between banks and their clients at various stages of litigation and a significant source of earnings to litigation lawyers. It is difficult to identify the causes – client greed or ignorance versus dealer greed or misrepresentation.

Current regulatory proposals do not deal with the issue of complexity in derivative products. Regulators could have forced standardisation and listing of derivative contracts, only allowing them to be traded on exchanges. They have favoured, probably correctly, the need to customise products and structures for users and their needs.

In relation to product suitability, the BIS have proposed “pharmaceutical” style warning systems, which do not address the problem. Given significant information and knowledge asymmetry between sellers and buyers, the possibility of disallowing certain types of transactions altogether or with certain parties should be considered.

Such proposals are likely to be unacceptable as inconsistent with “freedom of choice”. “Free market” advocates are likely to side with the view of an anonymous commentator: “Nine out of ten people who change their minds are wrong the second time too.”

Satyajit Das is the author of Extreme Money: The Masters of the Universe, Financial Alchemy and the Cult of Risk (forthcoming) and Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives – Revised Edition (2010).